In response to the abuses that led to the Great Depression and its devastating impact on individual investors, Congress passed the Securities Act of 1933, also known as the “Truth in Securities Act,” which regulated interstate sales of securities, along with the Securities Exchange Act of 1934 which regulated sales of securities in the secondary market and created the Securities & Exchange Commission (SEC). A security is a certificate or other financial instrument that has monetary value and can be traded, i.e. stocks, bonds, derivatives, etc. Basically, the SEC was created to protect people from being scammed. They accomplish this goal by regulating the securities industry and specifically by determining the criteria for being an accredited investor.
As the term implies, “accredited” investors are “officially recognized or authorized” as sophisticated and/or capable of investing in higher-risk, unregistered investment vehicles. The SEC under Regulation D establishes the requirements for such individuals based on income, net worth, asset size, governance status, or professional experience. In order for an individual to be considered an accredited investor they must meet one of the following requirements:
- Annual income of $200,000 (or $300,000 joint income if married) for the past 2 years with the expectation that one will earn the same or more in the current year.
- Minimum net worth of $1,000,000 either individually or jointly if married. One’s personal residence is not included in their net worth, but neither is their mortgage counted as a liability. Net worth is defined as assets minus liabilities or what you own minus what you owe.
- In 2016, Congress included registered brokers and investment advisors as accredited investors along with individuals that can prove sufficient education and/or job experience in unregistered securities.
If membership has its privileges, what’s so great about being an accredited investor? First, as the status denotes, accredited investors are financially stable, experienced, and knowledgeable. They understand the risks involved in an investment and/or have the resources to absorb reasonable losses. Second, whenever dealing with the government there is a cost associated with “red tape.” Regulatory filings and compliance can be costly. As a result, investments that can be offered directly to accredited investors are able to produce a higher return (by lowering costs). The final point is a combination of the previous two. The exclusivity of investments available only to accredited investors makes them valuable. Furthermore, the sophistication of the investors provides validation for the investment vehicle, itself. If such investments weren’t solid, safe, etc. they wouldn’t exist because no accredited investor would risk investing in them.
You can fool all the people sometimes and some of the people all the time, but you’d be hard-pressed to fool a bunch of high net worth individuals with investment experience.